WHY WOULD ANYONE WANT TO TAKE A RISK? THE RISK PREMIUM
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Investing is risky. So why don't you just leave your money in
the bank? The answer, of course, is that by taking a risk you hope
to have greater rewards. This simple concept is the backbone of
The risk premium is the amount by which the
rate of return on a risky investment exceeds the rate of return on
a less risky investment. The extra return on the risky investment
compensates the investor for taking on risk.
The rate of return on an investment with zero risk is
called the risk-free rate.
U.S. Treasury bills carry so little risk they are said to be
risk-free investments; therefore we can use the rate of return on
T-bills to approximate the risk-free rate. If you are investing in
any firm less reliable than the U.S. Government, you expect your
returns to increase along with the risk.
To better understand these concepts, let's
look at some numbers. The next section offers you a view of rates
of return for various classes of assets.